Monthly Partner Memo - December 2021

November 29, 2021 | Paul Chapman


Take comfort in the knowledge that your capital is being managed the way your friends complain they wish theirs was managed.

"Everybody has a plan until they get punched in the mouth." – Mike Tyson

Disclaimer: Note that the contents of this memo are all my thoughts, and not that of RBC or RBCDS.

Friends & Partners,

It’s been so long since we’ve had a correction, most people have forgotten what a correction feels like. And aren’t prepared…

Your portfolio shouldn’t be invested based on short term news – period. But we are human, we are emotional, and we want simple explanations because we want to try and control our outcomes. And most of us act out of instinct – unfortunately. Investing is a long-term game that requires long-term patience at the risk of being constantly distracted from that effort. We’re tempted by headlines and market moves to act on a daily basis. Inaction and thinking long-term allows compounding to work its magic. The greatest challenge is ourselves.

People don’t change. Humans are motivated and flawed the same way today that they were 122 years ago. One of the best stock market predictions of all time was done in the early 1900’s, when John Pierpont (JP) Morgan was asked by reporters what the stock market would do next. He famously said: 'It will fluctuate.”

The outlook for equities generally remains positive (and as I keep noting given this stance so far, I certainly feel that I’m in the small minority as all the pundits you see on TV and read will have you believe that the market is about to implode…). The bottom line is that rising COVID cases and new variants, debt ceiling and inflation concerns as well as fears around central bank rate hikes can and will cause volatility and pullbacks in stocks as we have learned. And while valuations are stretched, high valuations themselves don’t end rallies (they just help decide how far the drop is when something goes wrong).

As you know, however, a positive outlook doesn’t mean there aren’t risks for this market. The clearest risk over the medium term is that inflation does not recede and the Fed hikes rates more quickly than expected to reduce inflation, thereby killing the economic recovery. But tapering and killing a recovery are two different things, so while a more aggressive Fed can create more volatility, it doesn’t necessarily mean that equities are headed sustainably lower. Similarly, sustained inflation ultimately chokes off demand and negatively impacts corporate earnings. But we aren’t seeing that yet. And if inflation does not decline, it eventually will outpace wage gains, and that’s when corporate earnings can come under pressure as inflation eventually reduces demand.

As long as earnings remain stable and rising, bond yields are not aggressively moving higher putting downward pressure on the market multiple, then the medium- and longer-term outlook for stocks will remain supportive. But, valuations are high, making potential ‘air pockets’ and downside a significant risk, and noise and volatility will remain prevalent. We build our portfolios to weather choppy markets and minimize downside.

You can’t predict – but you can prepare.*


Covid – Should Recent News Change Your Outlook?


The new variant is admittedly scary, and the market’s reaction is to sell first and ask questions later. By the time you read this, there will likely be further news (positive or negative).

Source: FT

Moderna was the first company to be all over the “Omicron” variant, and expect the others to not be far behind. Their booster is the first wave of defense against the variant, with 3 different strategies already in motion to deal with it if the booster doesn’t work (one of the many benefits of an MRNA based vaccine platform).

While the variant is concerning due to new mutations of the spike protein, remember there is no research out that implies it can break through the vaccine. And, that remains the most important part of the whole COVID saga with regards to markets. Unless a COVID variant can breakthrough a vaccine or render the new therapeutics ineffective, then negative COVID-related news should not affect longer term investors.

COVID anxiety has been one of the main influences recently, but at this point this is not a bearish game changer.*


Don’t Get Scared Out of the Market

We all know (or should know) that timing the market is impossible. Anyone who claims to do it well is lying. But it certainly is difficult to hold onto stocks when things start to feel unstable, and the media does a great job of selling the negative headlines: and fill in that chart with positive headlines. You can’t. Because there are no positive headlines. Bill Gates said it best: “Headlines, in a way, are what mislead you, because bad news is a headline, and gradual improvement is not.”

So just remember:

Source: Bloomberg

Because timing the markets is a difficult task, and usually ends in failure:

Source: RBC GAM, Morningstar. S&P 500 TR USD. Jan. 1, 2020 to Dec. 31, 2020.


The Economy May Outperform the Stock Market in 2020

Given the high valuations in virtually every asset class, the returns we’ve experienced in everything from housing to stocks is unlikely to keep up their torrid pace. But the economy should continue to fire into next year.

  • Companies will continue to invest in themselves: S&P 500 companies currently have $7 trillion of cash on their balance sheets, the most ever. They plan to spend this cash on equipment and other capital expenditures, which will support the economy, along with corporate revenues and earnings down the road.
  • Inventory levels are low: This has largely been a function of increased demand, not just a supply problem. These inventories need to be restocked, so expect full tilt production levels for some time yet.
  • Supply chain issues should resolve themselves: This has been reinforced by accelerated supply chain activity in several Southeast Asian countries who’ve begun their vaccination programs and started getting employees back to work.

A recession also appears unlikely. The Conference Board publishes several popular indexes like Leading Economic Indicators. Their Coincident Economic Indicators index are less popular, but can be very useful – unlike leading economic indicators, which tries to project future conditions, coincident ones look at current conditions. And looking at the ratio of both indexes may be even more useful.

The chart below shows LEI/CEI (leading over coincident indicators), which tends to start falling a few months before a recession begins. Since 1969 it signaled almost every recession quite accurately 2–9 months in advance, especially when the indicator turned down sharply. Today, this ratio is still rising, so a recession doesn’t look like a near-term risk on this metric:

Source: Advisor Perspectives


The Big Debate Still Remains Inflation

One of the key elements for equity markets is the outlook on inflation (and the potential for stagflation, which you can learn about here) – and this will ultimately drive Fed policy decisions and the timing of interest rate hikes.

Inflation concerns are certainly becoming widespread. FactSet recently reported the highest number of companies citing “inflation” on their earnings calls in 10 years:

The Fed believes that inflation is transitory. That outlook would be dependent on the resolution of several near-term risks – including supply chain constraints, COVID concerns, and labour supply issues. But potential headwind for the market is the expectation that central banks may have to raise rates sooner and more than expected if inflation pressures don’t subside (i.e. before the middle of 2022), which means the proverbial ‘punchbowl’ would be removed from the party. And the later the Fed waits to tighten policy, they may have to raise rates higher than planned to quell inflation, which could lead to recession.

However, if inflation does in fact subside, it would afford the Fed additional flexibility on the timing of rate hikes, valuations would likely find further support and the market would applaud this moving forward.

Regardless of which scenario unfolds, higher rates appear to be on the horizon. And while higher rates typically weigh on market valuations, they don’t necessarily spell trouble for equity markets. Historically, stocks rise during periods of rising rates – propelled higher by earnings growth.

So, given currently high valuations, it will be key to watch how fast earnings grow. Current market expectations call for 9% earnings growth in 2022, but expectations have undershot actual results for some time. The question is: if inflation stays high and forces the Fed to act soon, will this be enough?

Instead of being laser-focused on inflation figures however, we need to watch inflation expectations. Rising longer-term inflation expectations reflect potential changes in personal behavior—whereby businesses and consumers combat inflation by pulling forward demand at today’s prices (which, ironically, only makes inflation worse as more money chases limited goods). You see this when everyone rushes to the store to buy everything all at once in extreme examples. That type of behavior change is very hard for the Fed to reverse, and that’s why the Fed watches inflation expectations so closely. So, while the financial media is focused on inflation figures, longer-term inflation expectations actually moderated slightly over the past month, implying that inflation pressures could actually be slightly easing.

Either way, the first phase of the easy money-driven market is likely to be replaced by a more challenging year ahead. Position yourself accordingly…


Maybe Rate Hikes, Tapering and Increasing Interest Rates Won’t Tank the Market After All?

Many recall 2013 when the unanticipated tapering comments from the Fed made then unnerved equity markets initially. But remember, they were able to quickly overcome the short-term volatility thanks to a strong economy and solid earnings growth (sound familiar?). As well, equity returns after the Fed actually started to taper in 2013, and when they eventually ended their quantitative easing program, were both very strong.

The median historical record of equity valuations around initial Fed hikes shows generally stable P/E multiples interestingly:

Source: GIR

Source: RBC GAM, Bloomberg. Showing S&P 500 Index TR (USD).


The Bullish Comparison for Today’s Environment – The 1960’s

Jurrien Timmer, Director of Global Macro at Fidelity, offered the 1960s as a historical template for today’s markets. He believes that the macro backdrop won’t change much until S&P 500 reaches 8000 in about five years' time (that’s almost double from here!).

“The ‘60s comparison is compelling, especially now that we’re going to have higher capital gains taxes 4–5 years after a cut in income taxes. The parallel is the Kennedy/Johnson tax cut of 1964 followed by the Nixon tax hike in 1969. It was “guns and butter” back then. Now it’s Covid and a progressive capital-to-labor wave. The late '60s had social unrest and a speculative frenzy in growth stocks—sound familiar? In my view, our current inflation rate essentially mirrors where things were in the 1966–1967 time frame, before inflation really took off.”

A Wonderful Philanthropy Event Last Month

In partnership with Women, Worth & Wellness, I was able to sponsor and co-host a wonderful event focused on empowerment through philanthropy. We had wonderful speakers and attendees that rallied around such a worthy cause in mental health and wellness along with the Georgian Triangle Humane Society. You can see a short video highlight reel of the event HERE.

There are many ways to give back and integrate philanthropic giving into your life while also meeting personal planning objectives. I’ve written an article on this subject (and others) that you can find here.

Disclaimer: Note that the contents of this memo are all my thoughts, and not the views of RBC Dominion Securities.